Understanding Financial Systems

Introduction to Financial Systems

• A financial system is a complex network of interconnected financial institutions, markets, instruments, and services.
• Its purpose is to mobilize funds from savers and allocate them to productive investments.
• It creates a connection between investors and depositors, directing funds across different economic sectors.
• Financial systems are heavily regulated due to their involvement in monetary exchange and wealth management.
• Regulators are responsible for safeguarding investments and promoting their allocation towards productive avenues.

Functions of a Financial System

• Encourages savings by providing diverse financial products that offer returns and liquidity.
• Channels savings towards productive investments.
• Financial markets and intermediaries facilitate liquidity for businesses and investors.
• Insurance provides risk mitigation.
• Allocates credit efficiently and fairly.
• Contributes to economic development through capital formation.
• Facilitates fast payments and transaction settlements through advanced technology.

Journey of the of Indian Financial System

Pre-Independence

• British policies led to the "Drain of Wealth," preventing investments in productive sectors.
• The financial system faced limited funds, fewer instruments, few participants, and a lack of depth and transparency.
• The Reserve Bank of India (RBI) was established.

Post-Independence

• India adopted a socialistic planned development approach starting in 1951.
• The banking sector underwent nationalization in 1969 and 1980.
• The 1990s saw liberalization and a move towards a mixed economy.
• Financial stability replaced financial volatility.

Financial Neutrality to Activism

• The government started playing a more active role in the financial sector after independence.
• The RBI, initially a private institution established in 1935, was nationalized in 1949.
• The Imperial Bank of India was nationalized and renamed State Bank of India (SBI).
• The Banking Regulation Act was enacted in 1949.
• 14 commercial banks in 1969 and six more in 1980 were nationalized.
• General Insurance was nationalized, and the General Insurance Corporation was established in 1972.
• Development banks, such as IFCI and ICICI in 1955, were set up.
• The Unit Trust of India (UTI) was established to pool savings for productive investments.
• Financial concerns led to the creation of the Small Industries Development Bank of India in 1990.

Critique of State Domination of the Financial Sector

• Nationalization resulted in a shift in emphasis from industry to agriculture.
• Rapid banking expansion occurred in rural areas
• The banking sector was affected by bureaucratic inefficiencies, lack of competition, limited capital, and weak controls.
• Financial repression occurred as the government controlled credit allocation and pricing.

Financial Volatility to Stability

• India initiated financial sector reforms in 1991 due to near bankruptcy.
• The Washington Consensus by IMF and WB urged economic liberalization, privatization, and globalization.
• The focus moved from nationalization to privatization, fostering private business growth.
• Deregulation resulted in abandonment of licence raj.
• Sectors like banking and insurance were opened to private and foreign capital.
• SEBI was formed to regulate the rapidly growing capital markets.
• In 1999 the IRDA was established to regulate the insurance sector.
• India transitioned from restrictive FERA to liberal FEMA amid forex growth.

Narasimham Committee

• The Narasimham Committee was established in August 1991, under M. Narasimham.
• It reviewed all aspects of the Indian financial system.
• The committee's report provided comprehensive financial sector reform recommendations, including banking and capital markets.

Recommendations of the First Narasimham Committee

• The Statutory Liquidity Ratio (SLR) should be reduced to 25%, and the Cash Reserve Ratio (CRR) to 10% over a time period.
• The priority sector should include marginal farmers, tiny sector, small businesses, transport, village and cottage industries.
• Banks should be allowed to set their own interest rates through deregulation.

Recommendations of the Second Narasimham Committee

• Defined and categorized Non-Performing Assets (NPAs) and suggested transparency in the banking system.
• Recommended tribunals for loan recovery, handling doubtful debts, restructuring banks, and allowing new private banks.
• Increased capital adequacy standards to strengthen the banking sector.
• Proposed equal treatment for foreign banks with Indian private banks.
• The segregation of the RBI into a regulator of banks and owner of the bank was suggested.

Implementation of Recommendations

• The SLR decreased from 38.5% (1991-1992) to approximately 28% within five years.
• The CRR has also decreased from 14% to 10% by 1997.
• The RBI introduced the Capital to Risk Weighted Asset Ratio (CRAR) in 1992 to strengthen the banking sector.
• The RBI introduced prudential reforms for classifying assets and provisioning NPAs.

Financial Sector Legislative Reforms Commission (FSLRC)

• FSLRC was formed by the Ministry of Finance in March 2011 to review and revise financial system legislation in India.
• The current regulatory structure is fragmented with gaps, overlaps, inconsistencies, and opportunities for arbitrage.
• The FSLRC's 2013 report reviewed the regulatory structure and proposed the Indian Financial Code.
• The draft Code is principles-based and non-sectoral, unifying laws across the financial system.

Draft Indian Financial Code

Consumer Protection

• Regulators must ensure consumer protection by financial firms.
• The draft Code grants rights to consumers and establishes a unified Financial Redressal Agency (FRA).

Micro-Prudential Regulation

• Regulators should oversee and minimize the risk of failure for financial firms. -Five powers for micro-prudential regulation were specified: regulating entry, managing risk, absorbing losses, governing, and monitoring

Resolution

• In the event of failure, firms should be swiftly dissolved with the interests of small customers as a priority.
• A special corporation should intervene firms close to failure.

Systemic Risk

• Regulators should intervene to reduce risk for the financial system.

• The FSLRC suggest that the Financial Stability and Development Council (FSDC) should be a statutory agency.

• The draft Code moves toward a system where the RBI regulates banking and payments.

• A new Unified Financial Agency would take over existing regulators (SEBI, IRDA, PFRDA, and FMC).

• The FSLRC proposed a Financial Sector Appellate Tribunal (FSAT) to hear financial appeals.

Challenges Before the Financial System

• Risks increase with global market integration.
• The 2007-2008 financial crisis was an example of the risks involved.
• Financial innovations and new financial intermediaries are emerging with tech adoption.
• Rising levels of Non-Performing Assets affect the banking sector.
• India is urged to synchronize with regulations and BASEL norms & IFRS international accounting standards.
• Governance and capital market scandals pose a major challenge.
• Lack of financial resources restricts long-term infrastructure financing.

Role of the Government

• Establishes regulations for financial markets and services.
• Promotes financial infrastructure development.
• Encourages financial inclusion.
• Plans the efficient use of economic resources and productive allocation of funds.
• Acts entrepreneurially through involvement and ownership in public sector enterprises and banks.

Components of the Financial System

• Financial Institutions
• Financial Markets
• Financial Instruments
• Financial Services
• Financial Regulators

Financial Institutions

• Financial institutions are intermediaries between investors and borrowers and provide different financial services.
• Financial institutions facilitate the flow of money.
• Types of Financial Institutions include:
  • Commercial Banks
  • Central Banks (e.g., RBI)
  • Non-Banking Financial Companies (NBFCs)
  • Insurance Companies (e.g., LIC, ICICI Prudential)
  • Mutual Funds
  • Pension Funds
• Non-banking financial institutions do not have demand deposits or engage in payment systems.
• Banks include commercial, cooperative, regional rural (RRB), and small finance banks.
• NBFCs include investment banks, AMCs, and insurance companies.
• Financial institutions ensure continuous capital for businesses while accelerating economic development.
• They gather savings from small investors and direct them towards productive investments.
• They also provide marketing and liquidity to instruments.
• They help develop a healthy capital market via underwriting, merchant banking and syndication.
• They provide professional services to both businesses and individuals.

Financial Markets

• Financial Markets include:
  • Money Market - Short-term instruments
  • Capital Market - Long-term investments
  • Primary Market - New securities (IPOs)
  • Secondary Market - Trading existing securities
  • Foreign Exchange Market (Forex) - Currency trading
  • Commodities and Derivatives Market - Futures, options, and swaps
• Financial Markets can be further classified as organised and unorganised.
• Organised markets include stock exchanges such as BSE and NSE in India.
• Financial Markets mobilize savings for investments.
• They also assist with capital formation.
• They provide long term avenues to investors for high returns by investing in instruments, equities and mutual funds.
• They enhance economic growth via employment and infrastructure.
• Market funds are continuously accessible, fostering investment or finance raising.
• Capital Markets directs investments between suppliers and users, such as individuals, businesses, and governments.
• Vital to functioning of economy since capital is a critical component for generating economic output.
• Capital Markets issue long term debt and equity to corporates and government.
• The capital market has primary and secondary market segments.
• The Primary Capital Market issues new long term and medium term debt and equity.
• Issuance is through private placement to friends, relatives and financial institutions or by making a public issue.
• It uses free pricing of shares
• An Initial Public Offering (IPO) occurs at the first issuance.
• A follow on Public Offering (FPO) occurs after the IPO.
• A rights issue is the issue of rights to existing shareholders.
• The Secondary Capital Market buys and sells of already issued securities.
• It provide liquidity to securities from the primary market.
• It allows securities to be valued quickly.
• The Money Market handles short term funds.
• It provides financial assets that can be substituted for money.
• Money market instruments are liquid and equilibrate the short-term finances for lenders and borrowers.
• The call and notice money market is a key Money Market segment.
• Under the call money market, funds are transacted on an overnight basis while the notice market carries funds between 2 and 14 days.
• Term money market refers to funds transacted for more than 14 days up to a year.

Financial Services

• Financial services encompass commercial banking services.
• These services facilitate wealth management, tax advice, and corporate mergers.
• Commercial banking services are important as they safeguard deposit and provide lending services.
• Investment banks offer a lot of following banking solutions: wealth management, advice on mergers and acquisitions etc…
• Insurance is another component to industry.
• They supply venture capital and allow ownership in enterprises.
• Hedge funds and mutual funds invest for management fees.
• The wider sector provides accounting and tax assistance.
• Financial services are unique as they involve dynamic and intangible features.
• In intangible services, customers rely on trust, brand trust and reliability.
• Other services are custom based and customer based like insurance, loans and investments.
• Finally they are dynamic, meaning consumers get these services immediately.
• RBI regulates banking and NBFCs while SEBI Regulates stock.
• IRDAI Regulates Insurance while digital technology enables the provision of quick UPI services.
• The sector is continuously changing and growing and uses technological innovation.
• It is providing new Al wealth to its consumers while improving.
• Financial services provide capital through loans and insurance while maintaining a strong and stable economy.
• Fund based features loans and leasing while non fund features bank guarantees management services and broking service.

Financial Instruments

• They are contracts or securities that are monetary and help with finance transactions.
• Instruments include equity ones (shares etc) or debt ones (Treasury bills).
• Debt Instruments feature bonds, debentures but equity includes shares and preferences.
• Market ones include (derivatives swap etc) and Hybrid ones are warrants.
• These instruments are loan from investor that can be promised to repay.
• Bonds are generally long term while Debentures are unsecured ones.
• T Bills however are short term and commercial papers are corporate ones.
• CDs are bank issues with fixed borrowing government securities.
• Equities are entitled to dividends and voting rights.
• Derivate Instruments derive value from assets.
• Futures agreement by sellers or buyers at pretermined price while option give the right.
• Swaps are an exchange.

Financial Regulators

• Regulators watch financial system to maintain customer protection and transparency while ensuring safety.
• The RBI helps to protect the India with stock markets regulated by boards.
• Finally the IRDAI protect loans.